NEW YORK, Oct 1 (Reuters) - Venture capitalists show no sign
of shying away from investing in startups related to Bitcoin
even as authorities step up their scrutiny of the virtual
currency and its possible connection to money laundering and
other illegal activities.

Investment has jumped in recent months as Bitcoin, the
prominent digital currency not backed by a government or central
bank, has begun to gain a footing among businesses and
consumers, a key step for it to go mainstream.

Startups such as Coinbase and BitPay Inc, which help
facilitate bitcoin adoption by merchants and consumers, have
raised millions of dollars so far. Interest is also growing in
bitcoin trading, investment funds, and "mining" - the process of
creating the digital currency.

Bitcoin, until recently a niche alternative currency touted
by computer geeks and anti-government advocates, has garnered
attention from a growing list of notable investors such as
Andreessen Horowitz, which has invested in Facebook Inc,
Twitter and Groupon Inc, and Founders Fund, which
includes three founders of PayPal. Some devotees promote
Bitcoin, which exists solely in cyber form, as the future of
money, and in some investing circles it has created a buzz
reminiscent of the early Internet age.

"What keeps me up at night is 'are we missing out on
investments?' because if this is what I think it can be, we will
regret not being even more active," said Micky Malka, founder of
Palo Alto, California-based Ribbit Capital, which has invested
in three bitcoin firms, including San Francisco-based Coinbase.

Bitcoin startups raised nearly $12 million from venture
capital investors in seven deals in the three months ended June,
according to CB Insights, a New York-based venture capital data
firm. That compares with just five deals totaling less than $2
million in the previous four quarters.

More money is expected to flow into the bitcoin market,
where the amount of venture capital financing remains modest
compared with some sectors like social networking. Some industry
participants estimate available money for funding ranges from
$65 million to $100 million, while the number of bitcoin
startups in the United States is probably in the hundreds.

Last week, SecondMarket, a platform for facilitating
investment in privately held companies, launched the Bitcoin
Investment Trust, which allows sophisticated investors to gain
exposure to the price movement of Bitcoin without the risks of
direct bitcoin ownership.

The move comes three months after Cameron and Tyler
Winklevoss, the twin brothers famous for their legal battle with
Mark Zuckerberg over the founding of Facebook, filed plans to
launch the Winklevoss Bitcoin Trust, an exchange-traded product
that would allow investors to trade the digital currency like
stocks.

There are 11.7 million bitcoins in circulation, with a
market capitalization of over $1.7 billion. The price of bitcoin
is currently around $142, down from more than $250 in April.

Investors say they expect Bitcoin to grow in popularity in
businesses related to storage, payment processing, remittance
and micro transactions. The key is finding the right
entrepreneurs to build the best consumer-friendly applications.

Coinbase, a virtual wallet and platform where merchants and
consumers can do business using Bitcoin, said on its website
that it has about 282,000 users and handles 175,000 transactions
a month. The firm has raised more than $6 million.

Fees charged by bitcoin firms are typically far less than
those charged by banks, credit card companies or other online
payment processors. Coinbase charges merchants a 1 percent fee
to convert Bitcoin into local currencies, but is currently
waiving it for the first $1 million.

Atlanta-based BitPay charges a flat 0.99 percent fee. The
firm, which has raised $2.7 million, said over 10,000 approved
merchants in 164 countries use its platform to accept bitcoin
payments.

Supporters say using Bitcoin offers benefits including
faster speed, lower fraud risk and increased privacy, though
critics argue the anonymity it offers makes the currency a
magnet for drug transactions, money-laundering and other illegal
activities.

HIGHLY RISKY

Regulators have ramped up scrutiny of digital currencies. In
August, New York's top banking regulator issued subpoenas to
about two dozen companies associated with Bitcoin. Earlier this
year, U.S. prosecutors accused Liberty Reserve's Costa
Rica-based operations of laundering about $6 billion.

Legal troubles can also deter investors. In July, a lawsuit
was filed against New York-based BitInstant LLC, accusing the
firm of making "false representations about its services and the
inflated fees that it failed to refund as promised." BitInstant
operates a platform for bitcoin transfers and has received $1.5
million from the Winklevoss brothers.

BitInstant CEO Charlie Shrem said the firm "is committed to
doing the right thing and it will be vigorously defending itself
against these allegations, which it believes are not true."

Bitcoin advocates say a lot of the concerns have to do with
fear of the unknown, and more regulatory clarity will bolster
the currency's use. Until then, bitcoin investing will remain
highly speculative.

An added risk is that, unlike investing in startups in
established areas such as social media, generating long-running
returns from a bitcoin company relies on the currency proving to
be more than a passing fad.

Even some active players do not give high odds to that:
BitPay Co-founder and CEO Anthony Gallippi estimates an 80
percent chance the value of bitcoin could go to zero.

Still, given the prospect, however slim, for a big windfall,
investors with the right risk tolerance are finding it
appealing.

"We believe that bitcoin may have significant upside given
the size and scope of the industries that potentially are
impacted by bitcoin," said SecondMarket Founder and CEO Barry
Silbert in New York. "However, bitcoin also faces regulatory
uncertainty and widespread adoption issues that make investing
in bitcoin a highly risky endeavor."